Each day, it seems a new rumor is produced and the stock markets shifts accordingly. The seesaw action can take a toll on a trader’s emotions.

One way to gauge an underlying trend in the market is through the risk appetite of investors. The benefit of understanding the mood of the market is it allows you to align your trades in the direction of the market sentiment.

When you see the stock market increase significantly, that is an indication that risk is “on.” A “risk-on” environment is a mood of the market where investors feel good about the future prospects of the economy.

Therefore, they take their capital and speculate in the stock market and high-yielding instruments. This generally increases the value of the stock market and high-yielding currencies, which lately are the Australian dollars (AUD) and New Zealand dollar (NZD).

At the same time, low-yielding instruments tend to gain less on a relative basis or possibly even lose value. Low-yielding currencies tend to be sold to fund the purchase of a higher-yielding currency. This selling of a lower-yielding currency while simultaneously buying a higher-yielding currency is called “the carry trade.”

So among the effects of risk-on sentiment is an increase in the stock market and demand for high-yielding currencies. As a result, the carry trade strategy tends to perform well.

Watch the video at the end of this article for more information about carry trades.

In the chart below, since the AUD has historically been a high-yielding currency, when the risk sentiment was “on” (green shaded areas), the AUD/USD exchange rate was likely to rise and the carry trade strategy worked well.

Click to Enlarge

When the risk sentiment turned “off” (pink shaded areas), the AUD/USD exchange rate tended to fall and the carry trade strategy would not have performed consistently.

When you see the stock market fall like we did earlier this week, it is labeled as “risk off” in the media. That means investors and traders are averse to risk—they want to avoid risk and risky instruments.

Therefore, investors pull their money out of stocks by selling their shares and risky instruments like high-yielding currencies. In a risk-off market, the carry trade does not work. Although a trader is gaining a daily dividend, the movement of the exchange rates is so adverse that it wipes out any interest gains.

In a risk-off environment, traders are better served buying safe-haven currencies like the US dollar (USD) or Japanese yen (JPY). (Until August 2011, the Swiss franc (CHF) was also considered a safe-haven currency, but the recent intervention by the Swiss National Bank is trying to curtail the buying of the franc.)

The risk assets like the US stock market and high-yielding currencies like the AUD are near resistance levels. This may mean a return to risk aversion and a selloff in the stock market and AUD/USD.